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- SSE seems to be a highly levered Chesapeake spinoff left in a challenging environment of high capex requirements.
- On a positive note, insider interests seem aligned and institutional investors are interested in the company.
- Compelling investment opportunity in case current capex results in significantly increased gross margins.
Spinoffs tend to be a lucrative investment opportunity on average, according to many academic studies. This thought seems to be confirmed in practice by an investment track record of various successful investors including Joel Greenblatt (Trades, Portfolio).
Previously mentioned investment legend uses his book (with a catchy title: You can be a stock market genius) to list spinoffs as "one of the secret hiding places of stock-market profits." According to his book there are five reasons why a company would do the spinoff:
- Separate business can be better appreciated by the market.
- Management wants to separate the "bad" from the "good."
- Spinoff as way to get value to shareholders for a business that can't be easily sold.
- Tax considerations.
- Solution to a strategic, antitrust, or regulatory issue.
Given the appropriate price, there are obviously spinoffs rational investor would prefer to others.
Luckily Joel Greenblatt (Trades, Portfolio) kindly lists the selection criteria one should follow in order to improve this "average" (it seems that already significantly above market) returns one could expect to gain out of an average spinoff situation:
- Institutions don't want it (and their reasons don't involve the investment merits).
- Insiders want it.
- Previously hidden investment opportunity is created or revealed.
Chesapeake solution to a strategic issue
On February 24, 2014, Chesapeake (NYSE:CHK) announced that it is pursuing strategic alternatives for its oilfield services division, Chesapeake Oilfield Services, including a potential spinoff to Chesapeake shareholders or an outright sale. The company stated the reasons for doing so on pages following page 56 of its 10Q report dated April 30, 2014.
- Focus on existing assets fitting its strategy.
- Reducing financial complexity and lower the overall leverage.
Its strategy included sale of other assets including equity stakes, buildings, equipment and land.
On March 17, 2014, its wholly owned subsidiary, Chesapeake Oilfield Operating, LLC, filed a Registration Statement on Form 10 with the SEC. COO would later convert into a corporation and change its name to Seventy Seven Energy (NYSE:SSE).
The company
The Oklahoma-based oilfield services company conducts its business through four operating segments: Drilling (Nomac Drilling), Hydraulic Fracturing (Performance Technologies), Oilfield Rentals (Great Plains Oilfield Rental) and Oilfield Trucking (Oilfield Trucking Solutions). In 2014 its total revenue amounted to approximately $2.1 billion –Â a bit over 42% generated by hydraulic fracturing operations followed by 37% generated by drilling operations. Operating cost of $1.6 billion is distributed in a similar way, 46% arising from hydraulic fracturing and 32% from drilling.
While the operations seem to be gross margin positive they have required significant capex in recent years, indicating challenging competitive environment.
Their high dependence on CHK for a majority of their revenues (81%, 2014), level of indebtedness and the cyclical nature of the oil and natural gas industry don't make this situation any easier.
Institutional investors seem to like the company
Its market capitalisation amounts to $305.99 million according to Yahoo! (YHOO, Financial) Finance as of June 22, 2015, compared to CHK market capitalisation of $7.82 billion.
56.1% of outstanding shares is currently owned by institutions. Icahn Capital (8.6%), Owl Creek Asset Management (4.8%), The Vanguard Group (3.9%) and BlackRock (3.6%) are among top shareholders. All but Icahn Capital, whose exposure remained unchanged, have slightly decreased their exposure to common stock equivalent of the company measured against their peak bet.
Insiders want it
Insiders own 6.6% of total shares outstanding, at the moment of writing this amounts to below $20 millio. The following insiders own the highest percentage of shares outstanding: CEO (2.3%), CFO (1.1%), and the president of Nomac Drilling (1.0%). Others follow with stakes below 1% of common shares outstanding.
Comparing their stake at current market prices to their base salary as reported in the latest proxy statement, the ratio of base salary to current stake amounts to 7.1x for CEO and 6.3x for the CFO respectively.
Concluding thought
The company seems to be highly leveraged and may incur additional debt in the future. As of December 31, 2014 they had $1.6 billion of total indebtedness. Their debt levels have increased slightly since, according quarterly fillings. Their capex would need to decrease significantly as a percentage of gross margin in order to make this stock a compelling investment opportunity.
If current capex spending does not bring at least short term competitive advantage, resulting in higher revenues and margins, the company is likely to go one of the following ways:
- Continue to increase indebtedness
- Issue shares
- Being acquired
- Sell assets
- Reduce spending
If companies expenditures prove to be "one off" in their nature, this might turn out to be a compelling multi-year investment opportunity. We are certainly talking an interesting company here, but I don't see it as a no-brainer at this point. For now it seems that the cash flow from investing on average exceeds cash flow from operations by a quite significant margin, resulting in increasing indebtedness.
What should an individual shareholder do in this situation? Your thoughts and comments appreciated.
Disclaimer: The opinions in this article are for informational and educational purposes only and should not be considered as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. It is not recommended that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
